Following on from my last two posts about influential value investor Martin Whitman (Trades, Portfolio), after his death earlier this week, let's do a deeper dive into his strategy. Specifically, let's look back at some of his comments on the topic of accounting and how various styles of accounting can impact a company's net asset value.
Whitman achieved the record he did for investors by focusing solely on a company's balance sheet. He looked at the value of assets on the balance sheet, and the ability of the company to be able to grow its net asset value, rather than concentrated on earnings growth, which he believed was much more difficult to predict. The theory was that if a company was trading at a discount to its net asset value, and it was growing this value, then investors would be sure to do well, if not from a closing of the intrinsic value gap, then from net asset value growth.
However, Whitman was also highly critical of different accounting standards. For example, he believed that GAAP accounting gave the best reflection of a financial company's net worth, although he preferred IFRS accounting standards to calculate the net worth of companies with a large amount of real estate on the balance sheet. As he explained in a shareholder letter to Third Avenue investors during 2014:
"Is NAV, or book value, a good indicator of wealth in conservatively financed companies? The answer is yes and no. TAM focuses very much on the common stocks of companies where the NAV is readily ascertainable. Frequently it is not readily ascertainable. There are two widely used accounting standards used in the investment world: Generally Accepted Accounting Principles (GAAP) used in the U.S.A. and International Financial Reporting System (IFRS) used in the rest of the world.
Does GAAP give a good approximation of NAV for financial institutions? Mostly yes. The assets of financial institutions are mostly paper which can be readily valued. The problem with many financial institutions is not valuing assets, but that it may be hard to ascertain what the real liabilities are. For example, in the case of many non-life insurance companies, especially casualty underwriters, the bulk of the liabilities will be determined by future events (e.g., hurricanes) which tend to be unpredictable.
Does IFRS give good approximations of NAV for companies whose assets consist largely of income-producing real estate? The answer is yes. Under IFRS income-producing real estate is carried on the balance sheet at appraised value with the appraisals conducted by recognized independent appraisal firms."
This letter goes on to say that outside these two sectors, neither of these standards are very good at calculating net asset value. It seems in most cases, Whitman believed that calculating net asset value was challenging, if not impossible:
"Do GAAP or IFRS give good approximations of NAV for going concerns engaged in manufacturing, distribution, or transportation where individual assets are not separable and saleable without jeopardizing going concern operations? The answer seems to be definitely no in most cases. Do GAAP and IFRS, for companies that are not well financed, or do not have easy access to capital markets, give good approximations of NAV? The answer is no in most cases. Indeed when a company is not well financed, large book value may be a negative factor. Frequently large book values tied up in, say, plant or equipment or inventories, may reflect very large overheads more than anything else."
This is an exciting insight into Whitman's strategy. Value investors, and indeed all investors depend on a company's numbers being correct -- an accurate reflection of the business's financial state. These figures will never be perfect, and it is critical to know their strengths and weaknesses. Whitman's strategy was based on calculating a company's net asset value, and for this, he needed the figures to be accurate. It is no surprise then that he conducted research on different accounting standards to find the best ones for the job. It is also not surprising to know that he favored real estate businesses in his portfolio, probably because, as explained above, their accounting net asset values were more reliable.
Disclosure: The author owns no stock mentioned.